Banking: Return on equity in a world of rising funding costs

People tend to think of the Turkish banking system as either very strong or very vulnerable, depending on the historical context. Following the bankruptcy of Lehman Brothers investment bank and the ensuing global financial crisis, many speculated that 2010 would be a difficult year for Turkish banks, along with their peers in the United States and Europe.

Indeed, loan demand dropped, and the possibility of credit rationing loomed large. Istanbul’s main stock index came off its hinges after Lehman’s collapse, hitting its lowest level on November 21, 2008. Non-performing loans (NPLs) were rising sharply and it looked like provisions for new NPLs could easily wipe out up to half of 2009 estimated net profits, at the then-current provisioning ratio of about 80 percent.

Foreign currency liquidity concerns rose amid worries about the magnitude of about $92 billion in gross private-sector debt due in 2009, including trade loans. The loan-to-deposit ratio fell as banks resorted to credit rationing. Fur- thermore, the syndicated loan market was expected to dry up in 2009.

The outlook looked rather grim for Turkey through the end of March 2009, when leading indicators that banks could indeed perform better than anticipated began to pile up. After March, bank equity shares drove a stock market rally and expectations lined up with the new realities quickly.

In the aftermath of the Lehman bankruptcy, there was much to worry about. However, the Central Bank of Turkey began easing rapidly, and that move proved essential.

The equity capital of the sector grew quickly after October 2008, expanding by 39 percent by the end of 2009. The growth in equity was due to retained earnings, as cash dividends fell to 27 percent of net profits in 2008 and to 16 percent in 2009. This compared to 47 percent in 2007.

So, about 30 percent of the change came from retained earnings, while 26 percent of the change in equity was due to valuation effects: securities portfolio booked as AFS (available for sale) gained value as interest rates fell and the gains went under equity unless such securities were sold whereas a 25 percent rise came from the current period’s net profit and 18 percent from capital increases. The above-trend growth of the equity base proved sustainable, and from then on equity continued to grow at a respectably high rate for about five years. Return on equity was high at about 20 percent, and capital adequacy was more than sufficient.

Weaker lira, profits

The problem arose during the last two episodes of rapid currency depreciation and were exacerbated as profitability also fell. Add to this rating issues and rising costs of funding from overseas, and you may end up predicting that a tough year lies ahead. Or does it?

First, loans account for 63.5 percent of total banking assets. Loans, especially consumer credit, lost momentum before the fourth quarter of 2016. However, macro-prudential measures that had effectively capped loan growth have eased in the last two quarters, and loans picked up anew as a result.

Loan growth stood at 16.5 percent annually in 2016. Part of the increase is due to the depreciation of the lira, which I do not expect to continue at the same pace this year. Hence, an estimate for 15 percent loan growth for 2017 is probably the consensus currently.

Since the deposits-to-assets ratio remains flat, at around 53 percent since 2014, and deposits grew in the fourth quarter of 2016, both in lira and forex, I expect this trend to continue.

Incremental changes make growth of 13 percent for deposits likely, if my currency scenario does not hold water. Banks’ 2016 net profit rise of 44.1 percent cannot be repeated. It was largely a one-off spike, given that there were strong base effects, and a sizeable increase in net interest income. Nevertheless, a profitability squeeze is not (yet) on the agenda.

Capital adequacy intact

Compared with previous years, 11 percent equity-to-assets does not look especially brilliant. However, we should not forget that the doomsayers’ expectations regarding capital adequacy did not exactly prove correct. Despite comments from Fitch Ratings and the currency depreciation, looking at a panel of 25 banks’ unconsolidated financials, we can state with confidence that capital adequacy stayed flat after December.

Obviously, the impact of zero-risk weighting for forex-denominated required reserves played an important role here, but nonetheless a 15.6 percent capital adequacy ratio – despite all the political risks since July 2016 – provides a good buffer, in my opinion. This is, admittedly an estimate that does not take into account changes in operational risks, and the addendum that

Despite comments from Fitch and the currency depreciation, looking at a panel of 25 banks’ unconsolidated financials, we can state with confidence that capital adequacy stayed flat after December

might come from new loan growth. Still, the ratio is satisfactory, as it is today.

Loan growth to stay at 15%

We tested financing capacity based on a few simple assumptions, and we repeated that test at different intervals. Unless there is a continual currency weakness that would eat into the capital adequacy, the system will be able to finance 14-15 percent loan growth going forward for five years.

We plugged in currency depreciation of 7 percent per year against the basket, with no capital injection to the system – equity increases coming only from retained earnings and a 30 percent annual increase in gross NPLs. What this is implies is an NPL ratio of 4.7 percent in 2021. This takes into account the compounding effect of recurring NPL rises, but consider also that some banks are able to sell a sizeable portion of bad loans, which they did in 2016.

Other assumptions we penned are in line with the last five years’ trends. In fact, they are slightly more pessimistic than what the trend tells us. Possible funding cost hikes to be fuelled by raising world interest rates and “selective screening” for emerging-market corporate debt do not make much of a difference, if loan interest rates can be adjusted. In other words, profitability and equity growth will depend on how much companies and households will be willing to incur the burden of rising funding costs.

Deposits flat

We also took into account the fact that the local deposits-to-assets ratio flattens and additional funding will come from non-deposit liabilities. We fed in a 5 percentage-point increase in the weight of foreign resources over a span of five years. Tapping international debt mar- kets increased by leaps and bounds after the global financial crisis, and internationally secured debt rose from about 5 percent of total liabilities to more than 20 percent. We put a cap on this at 27 percent of total liabilities in 2021. The system stands solvent, and the average return on equity stays at current levels, i.e., 11 percent.

2016 Asset composition

Obviously, on a lira basis, business loans seem to have increased more than they have, since 42.9 percent of such loans are forex-denominated. The lira depreciation plays a large role there, and we have to look at data in forex-adjusted terms. Then the increase is less impressive.

If the price is right

Still, we have seen again that both consumer and business loans can be triggered if constraints are relaxed, and especially when maturities are extended for consumer loans. Housing loans also rose as interest rates fell. I do not make any claims as to its sustainability, but we see that there is always a latent demand that can be rendered effective, if the right pricing is found.

NPL increases should not be expected to rise in a linear manner in the future. In the first half of 2016, NPLs continued to go up, as they did in 2015. But in the second half, NPLs were sold while interest rates fell. As a consequence, NPLs only increased by 0.14 percent in 2016.

There are many arrangements that contribute to less-than-expected NPL formation but at least there is no alarming upward trend. In fact, an NPL growth rate of 22.15 percent is less than my average assumption of 30 percent for the next five years, an assumption I used in the funding feasibility scenarios.

Liabilities 2016

We also see that deposits, which as a share of total liabilities remain flat, increased in the fourth quarter of 2016. The forex-adjusted rate of increase hovers at about 9 percent annually, and that is not so bad given the vicissitudes of the politics of the past. Non-deposit resources grew by 15 percent, and this will play a major role in determining loan delta going forward.

Funding costs

I do expect some pressure from that part’s funding cost, but again it will not be felt as a huge burden unless the U.S. Federal Reserve causes a storm in the emerging-market debt market. I do not expect this to happen before the second half of 2018 but at a time when the Fed is more likely than not to announce a path for balance sheet contraction. If the European Central Bank follows suit by raising the funding rate, that will be cause for heat in the corporate credit markets.

Last year’s bottom line surge should be seen as a one-off. Clearly, the Turkish Central Bank played a role there too. Curtailing reserve requirement ratios, adjusting the reserve option mechanism coefficients and the Banking Regulation and Supervision Agency’s move to reduce requirements for consumer and car loans had positive impacts on profitability. These were “doable,” in a sense, but they have been done already.

The key takeaway here is for temporary setbacks that do not constitute a secular trend, there is still room for maneuvering. Another key takeaway may lie in the answer to the question: To what extent can banks contain cost pressure and not reflect it entirely on loan rates, even if Turkish banking is oligopolistic, albeit moderately, according to the Herfindahl index, which measures the size of companies within an industry as an indicator of the amount of competition?

Going forward, the answer will depend on how much operating costs can be dispensed with, requiring a stricter stance on branch management, for example. However, variations in profitability are not the main yardstick to measure the overall performance of banking. The sector is mainly healthy, given estimated 15 percent loan growth and 10-15 percent growth in assets, deposits and equity.

Possible funding cost hikes to be fuelled by raising world interest rates and selective screening for emerging-market corporate debt do not make much difference, if loan interest rates can be adjusted.